Diworseification

Two years ago, we shared a post entitled Adequate Diversification, quoting from Warren Buffett’s 1966 Annual Letter to Limited Partners. There is one thing that the Oracle assured us: “If good performance of the fund is even a minor objective, any portfolio encompassing one hundred stocks (whether the manager is handling one thousand dollars or one billion dollars) is not being operated logically. The addition of the one hundredth stock simply can’t reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has on the overall portfolio expectation.”

At Broyhill, our top ten positions make up roughly 80% of the portfolio today and generate a current yield north of 4% (the expected yield on our estimates is much higher). While many active managers over-diversify to reduce volatility, most do so only to reduce the risk of underperforming and losing clients. As discussed in a recent paper, appropriately titled Diworseification, “Investors benefit from moderate diversification yet are made decidedly worse off when over-diversification dilutes strong security selection.” For our past, we prefer to concentrate our capital in our best ideas and avoid being bogged down by dozens of lower quality, lower conviction positions. While most “active” managers prefer to hide behind an index-like portfolio, the great majority of idiosyncratic risk is eliminated as the number of securities rises toward ten, as shown in the chart below.

The full piece is worth a read and includes a number of gems from value investing legends, which are highlighted below:

“Wide diversification is only required when investors do not understand what they are doing. Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.”

– Warren Buffett, Berkshire Hathaway

“As a result of overdiversification, their (active managers) returns get watered down. Diversification covers up ignorance. Active managers haven’t done enough research into any of their companies. If managers have 200 positions, do you think they know what’s going on at any one of those companies at this moment?”

– Bill Ackman, Pershing Square

“Diversification for its own sake is not sensible. This is the index fund mentality: if you can’t beat the market, be the market. Advocates of extreme diversification—which I think of as overdiversification—live in fear of company-specific risks; their view is that if no single position is large, losses from unanticipated events cannot be great. My view is that an investor is better off knowing a lot about a few investments than knowing only a little about each of a great many holdings. One’s very best ideas are likely to generate higher returns for a given level of risk than one’s hundredth or thousandth best idea.”

– Seth Klarman, Baupost Group

“The average mutual fund that holds 150 names goes that far out on the spectrum more for business reasons than for performance reasons. This is a profession where managers focus a lot on the question: ‘What mistake would it take to get me fired?’ The answer usually centers around underperforming by a certain amount, so they develop a strategy to minimize the probability of that outcome.”

– Bill Nygren, Oakmark Funds

“The idea of excessive diversification is madness. Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.”

– Charlie Munger, Berkshire Hathaway

“The right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.”

– John Maynard Keynes

“We don’t believe that widespread diversification will yield a good result. We believe almost all good investments will involve relatively low diversification.”

– Charlie Munger, Berkshire Hathaway

“We’re non-diversified. We focus. Why not buy more of your best idea rather than your 60th best idea? How many companies can I really know well over time and focus on, on a daily basis?”

– Bruce Berkowitz, Fairholme Funds

“Diversification is a surrogate – and a damn poor surrogate – for knowledge, elements of control, and price-consciousness.”

About Broyhill

We are a boutique investment firm, established as a family office and guided by a disciplined value orientation. Located in the foothills of the Blue Ridge Mountains, we operate outside of the fray and invest with a rational, objective, long-term perspective.